Better arbitrage opportunity for synthetic structured finance CDOs

Up until now, synthetic CDO technology has been predominately applied to corporate assets. With market fundamentals shifting, arrangers will more aggressively explore opportunities to apply this technology to structured finance assets, analysts said.

According to figures released by Standard & Poor's earlier this year, 93% of all CDO transactions rated in 2003 were synthetic, marking an 83% increase over 2002 volumes. About 64% of this activity was represented by single-tranche or correlation trades using multi-issuing vehicles and MTN programs to issue notes. This single-tranche platform has been primarily applied to investment-grade corporate assets.

But with an ever-increasing number of corporate defaults over the year pressuring synthetic CDO performance, paired with continued tightening of spreads for corporate names, investors are increasingly looking to structured finance products for better arbitrage opportunities.

Arrangers are starting to bring synthetic technology to ABS, RMBS, CMBS and CDO reference portfolios. According to a recent Fitch Ratings report, synthetic SF CDOs will likely emerge as a prominent asset class this year.

The structures function similar to synthetic corporates, the main difference being the underlying collateral.

"SF CDOs are designed to exploit arbitrage opportunities by taking advantage of liquidity/complexity premiums and the credit curve, to be a source of funding, or to manage balance sheet exposures," explained analysts at JPMorgan. "They have been growing as a portion of total CDO issuance." About 20% of total European CDO issuance is made up of SF CDOs. These have typically been focused in consumer ABS, prime RMBS and CDOs, according to JPMorgan analysis.

Structured assets offer a spread pickup and lower event risk, though they are comparable in default/recovery rates to similarly rated corporate credits. As corporate credits continuing to suffer performance backlash and downgrades, more investors are likely to eye the spread pickup for structured finance products.

In its report, Fitch highlighted the better ratings stability in structured finance compared to corporates.

"This spread pickup, as well as the opportunity to diversify exposures, is attracting a growing investor base, which varies by position in the SF CDO capital structure," said Fitch analysts. "Senior investors include banks, conduits, SIVs and finance companies. Equity investors are typically banks, pension funds, endowments, private banks, insurance companies, fund managers and hedge funds."

However, Fitch said the market would face challenges in SF synthetics, some of which are further along in corporate synthetics. "Credit event language should provide exact alignment of potential synthetic SF CDO losses experienced on the underlying SF securities in order to fully mitigate soft credit event risks (where a credit event may be called that is not immediately followed by default) and cash settlement risks," said analysts.

The agency also warned investors to beware of a potential mismatch between the final maturity of the deal and the referenced entity.

"There are a number of SF security types for which losses may be realized later than the initial delinquency," explained a Fitch analyst. "An example of this is RMBS, in which losses are generally not realized until the foreclosure process is complete."

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